The next class action frontier: Halliburton and fraud-on-the-market presumption

In Halliburton Co. v. Erica P. John Fund, Inc., the U.S. Supreme Court will decide whether to overrule or modify the “fraud-on-the-market” presumption of reliance in 10b-5 securities fraud class actions. The fraud-on-the-market presumption has helped plaintiffs surmount the class certification hurdle for over 25 years, and if it is overruled or modified, class certification in securities fraud cases may become a more challenging — and costly — endeavor.

Basic v. Levinson and the fraud-on-the-market presumption

Rule 10b-5, enacted pursuant to Section 10(b) of the Securities Exchange Act, prohibits misrepresentations or omissions in connection with the purchase or sale of securities. To prevail on a 10b-5, claim, a plaintiff must show, among other elements, a material misrepresentation or omission by the defendant, plaintiff’s reliance upon the misrepresentation or omission, and loss causation.

The fraud-on-the-market presumption was adopted by a four-member majority of the Supreme Court in Basic, Inc. v. Levinson to address what the Court saw as an “unrealistic evidentiary burden” imposed by the element of reliance in 10b-5 securities fraud class actions. Generally, the fraud-on-the-market presumption holds that “in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business.” Because “[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price,” “an investor’s reliance on any public material misrepresentations . . . may be presumed for purposes of a Rule 10b-5 action.”

Without the Basic presumption, it would be difficult, if not impossible, to certify most securities fraud class actions because individual questions regarding each plaintiff’s reliance on a particular misrepresentation would tend to predominate over issues common to the class.

The Halliburton case

The Halliburton case has a long history. In 2002, a group of plaintiffs, including lead plaintiff Erica P. John Fund, Inc. (EPJ Fund), filed a putative securities fraud class action against Halliburton alleging that Halliburton deliberately made various misrepresentations related to, inter alia, the scope of its potential liability from ongoing asbestos litigation.

In Halliburton I, the Supreme Court held that the court of appeals erred by denying plaintiffs’ motion for class certification and requiring plaintiffs to show proof of loss causation, i.e., a causal connection between the alleged misrepresentation and the plaintiffs’ loss, at the class certification stage. The Court vacated and remanded the case to allow the lower court to address any further arguments against class certification.

In the meanwhile, the Supreme Court issued its opinion in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds. In Amgen, a majority of the Supreme Court held that proof of materiality is not required at the class certification stage to invoke the fraud-on-the-market presumption. The Court reasoned that, because materiality is also an element of a 10b-5 claim, if plaintiffs fail to prove materiality it will not lead to the proliferation of individual issues but rather will end the case entirely. The Supreme Court’s decision in Amgen was notable not only for its holding but also for its concurring and dissenting opinions, in which several justices questioned whether the Basic presumption itself was still valid.

On remand, Halliburton argued that class certification was still improper in light of “price impact” evidence demonstrating that Halliburton’s alleged misrepresentations did not affect the market price of the securities. Halliburton reasoned that if a misrepresentation does not affect the market price of a security, an investor cannot be said to have relied on that misrepresentation merely because he purchased stock at the market price, and therefore the Basic presumption should not apply. The district court and court of appeals disagreed and granted plaintiffs’ motion for class certification. No doubt feeling emboldened by the justices’ statements about Basic in Amgen, Halliburton again petitioned the Supreme Court for review.

The arguments before the Court in Halliburton II

The Supreme Court will consider two questions on appeal. First, whether the Court should “overrule or substantially modify the holding in Basic to the extent that it recognizes a presumption of classwide reliance derived from the fraud-on-the-market theory.” Second, whether a defendant may rebut the presumption and defeat class certification by introducing evidence that the alleged misrepresentations did not distort the market price.

In addition to its legal arguments for overruling Basic, Halliburton asserts that, as a practical matter, the combination of the “fraud-on-the-market” regime and the court of appeal’s refusal to consider price impact evidence at the class certification stage makes certification almost automatic for any case involving a publicly-traded security that survives a motion to dismiss. This is especially problematic, argues Halliburton, because after class certification is granted the pressure on defendants to settle becomes so great that few cases are ever considered on the merits.

In response, EPJ Fund argues that, absent the fraud-on-the-market presumption, the opposite problem will occur and there will be few, if any, securities fraud class actions. This is worrisome from a policy perspective, argues EPJ Fund, because private class actions play an “essential role” in deterring securities fraud. EPJ Fund further asserts that adjudicating price impact at the class certification stage will lead to premature merits discovery and mini-trials.

The Justices spent a considerable amount of time at oral argument addressing these and other practical considerations of the decision before the Court.

Potential implications of the Court’s decision

The Court’s decision in Halliburton could fundamentally shift the class certification dynamic.

For defendants, the only truly disappointing outcome will be if the Court approves the status quo. Anything beyond that is likely to give defendants one more tool — either large or small — to defeat class certification.

Plaintiffs again find themselves in the hot seat following several terms of arguably pro-business class action rulings by the Court in such diverse areas as employment and antitrust. Any changes to the Basic presumption are likely to make class certification more difficult in securities cases. At best, class certification will become more expensive. Counsel for EPJ Fund emphasized at oral argument that preparing event studies to prove or to rebut price impact (or lack thereof) at the class certification stage is more complex and resource-intensive than it might seem because parties frequently argue about the confluence of factors that operate to change the price of stock on any given day. This often leads to discovery, expert reports, and expert testimony. At worst, securities fraud class actions may by and large disappear along with the Basic presumption itself.

To say that Halliburton is a case to watch is an understatement. It could be one of the most significant Supreme Court decisions in decades. Stay tuned.